Are the Risks of Derivatives Manageable - Essay Example

?Running Head: RISKS OF DERIVATIVES Are the Risks of Derivatives Manageable? In this paper the manageability of risks of derivatives as per the given text is discussed and evaluated. Derivatives are financial instruments (contracts / agreements) which become exercisable on the happening or non happening of any specific event. The ideas of Thomas A. Bass, who considers that the risks of derivatives are manageable are compared and evaluated with the ideas presented by Justin Welby who argues that the risks of derivatives are not manageable. As per the idea presented by Justin Welby, it can be said that if proper policies and procedures are implemented and maintained derivatives can be used as an effective way to cater and manage a lot of financial risks. However, strong controls are required so as to protect speculation and heavy losses to corporations because of the wrong or unethical use of these heavy duty financial instruments. Are the Risks of Derivatives Manageable? Derivatives and Risks of Derivatives Derivatives are financial instruments or contracts that are settled on occurrence or non occurrence of an event. As explained by Hu in his paper derivatives are the contracts that ‘allow or obligate’ the user / drawer of the agreement to buy or sell the underlying asset at any time in future at the specified cost / price. Hu also explained in his paper that changes in the value of the assets also changes the value of the said contract. This underlying asset can be interest rates, exchange rates, stocks, commodity, goods, etc. (Hu, 1993). Derivatives are either traded in derivative markets or can be directly made or created through any Financial Institution (including banks). Derivatives are widely used these days by corporate entities and other users in order to manage and control the risks associated with financial transactions and hedge the risks of changes in rates of commodities, interest rates, market conditions or foreign currency rates. Hu in his paper also points out the reasons to opt for the derivatives which are: 1. The costs of entering into derivatives contracts (also known as the transactional costs) are much less than buying the underlying assets; (Hu, 1993) 2. Further the risks of change in the price differential between the derivative and underlying assets can be arbitraged; and (Hu, 1993) 3. Derivatives help the users to ‘transfer the market risks’. (Hu, 1993) Derivatives can be in many forms and types ‘including futures, options, swaps, forwards, structured debt obligations and deposits, etc’ (Comptroller of the currency administrator of national banks website, 1997). These financial instruments pose many risks on the users and both the parties involved (that is the drawer and the drawee of the derivative contracts) which include the following risks as presented in the Comptrollers Handbook: 1. Risk of change in the price of investment portfolios, commodities or underlying assets / commodities; (Comptroller of the currency administrator of national banks website, 1997) 2. Risk of change in interest rates that may lead to increase or decrease in the prices of investment and earnings; (Comptroller of the currency administrator of national banks website, 1997) 3. Risk of changes in foreign exchange rates specially in case of currency derivatives or where more than one currency is involved; (Comptroller of the currency administrator of national banks website, 1997) 4. Risk of changes in equity or commodity prices in case of equity derivatives lead to risks on the prices and returns on derivatives; (Comptroller of the currency administrator of national banks website, 1997) 5. Risk of Liquidity or credit risks, which means the inability to discharge derivative obligations; (Comptroller of the currency administrator of national banks website, 1997) 6. Transactional risks that means the inability of the parties involved to carry out the derivatives transactions in an effective and efficient manner. (Comptroller of the currency administrator of national banks website, 1997) Comparison of the alternative ideas given by Welby and Bass On management of risks associated with the use of derivatives the ideas and conclusions of two authors Bass and Welby are discussed. In his journal Welby is of the view that the vast use of derivatives in the financial markets these days in order to reduce certain financial risks and control them is itself quite risky, however, the risks associated with the derivatives are quite manageable with the help of implementing ethical finance policies including transparency, governance etc. He is of the view that derivatives are those financial instruments that can be used to ‘alter the risk profiles’ rather than being the financial instruments used for speculation purposes only. (Newton, Englehardt & Pritchard, 2011). Welby also explained in his paper that the derivatives are very strong and powerful financial instruments which, if not properly monitored and if not used under proper control, may pose many risks to the corporation opting these instruments for hedging or risk management purposes. (Newton, Englehardt & Pritchard, 2011). Therefore, according to Welby the risks associated with the use of derivatives is quite manageable if proper monitoring and control procedures are implemented and effectively carried out. Welby argues that by the principles of transparency (proper audit and disclosures) and strict and practical laws governing the usage, recording, trading and disclosures of derivatives, the risks associated with these lethal financial instruments can easily be controlled and managed. On the other hand, Bass in his journal explains and argues that derivatives are a huge risk investment that leads to humongous losses. One of the examples of such losses is the loss suffered by Warren Buffet in the year 2007, wherein his investments (speculative) in the derivative financial instruments has lead to a loss of $1.6 billion along with a decline in stock markets and other derivative markets. As per Bass ‘Derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal’. (Newton, Englehardt & Pritchard, 2011). Bass explains in his paper that the control practice of improved transparency even cannot help in reducing and controlling the risks associated with the derivatives. One of the major reason for that is the complexity and ambiguity of all the derivatives transactions that in turn lead to difficulty in audit and disclosure practices or standardization of processes involved in the management and recording of derivatives. He also argues that the derivative markets are neither regulated nor recorded therefore it is quite difficult to estimate the size and risks associated with these markets and the traded instruments. But it can be easily said that it is huge and may lead to trillions of dollars of losses if the bearers of the instruments default in payment because of any reason. Therefore, as per Bass, risks caused by derivatives are huge and unmanageable, and derivatives are those complex and complicated financial instruments that lead to huge losses in the form of bad debts to everyone associated with them. (Newton, Englehardt & Pritchard, 2011) Managing the Risks associated with Derivatives Derivatives risk management is one of the crucial and most important issues of the financial markets, regulators and the companies these days. As explained by the TABB Group and the Bank of New York Mellon in their thought leadership series derivatives transactions are used by the regulators, investors, dealers and other corporate bodies. These organizations explained in their research that in order to effectively utilize derivatives and to control and cater the risks associated with the derivative transactions the regulators and market participants should develop, implement and maintain an effective governance and control structure that leads to proper management, recording, disclosure and handling of the derivative financial instruments in a way so as to reduce the risks to minimum levels. (TABB Group and BNY Mellon, 2010). In order to do so a proper framework of the operations and transactions related to the derivatives should be formulated. Such framework should ideally consist of appropriate and efficient laws and regulations to govern the derivative transactions, their recording, valuation, disclosures, transparency and dealing in those instruments. If properly formulated and implemented such a framework would lead to the following advantages for the management of the derivative financial instruments: 1. It plays an important role in reducing the risks associated with the derivatives; (TABB Group and BNY Mellon, 2010) 2. It leads to improvised transparency leading to proper and complete disclosures of all the derivatives transactions; (TABB Group and BNY Mellon, 2010) 3. It also helps in reducing the market and credit (including liquidity) risks associated with the derivatives; and (TABB Group and BNY Mellon, 2010) 4. It also helps is reducing transactional risks by improvising the operations related to the creation, valuation, recording, and trading of the derivatives. (TABB Group and BNY Mellon, 2010) TABB and BNY Mellon group also explain that development and implementation of proper and efficient reforms and legislations lead to control and monitoring of the derivative financial instruments, which reduce the risks related to derivatives to controllable levels. Conclusion Therefore, it can be said that although derivatives are quite complex and complicated instruments full of many risks. But these risks can be reduced and brought to minimum levels by developing and maintaining a proper system and control policies and procedures regarding derivative transactions. References Comptroller of the Currency Administrator of National Banks. (1997). Risk Management of Financial Derivatives. [Electronic Version]. The Comptrollers Handbook. Retrieved January 4, 2013 from http://www.alcopartners.com/RegulatoryDox/Controller_derivatives.pdf Hu, H.T.C (1993). Misunderstood Derivatives: The Causes of Informational Failure and the Promise of Regulatory Incrementalism. [Electronic Version]. The Yale Law Journal, 102(6), 1457 – 1513. Retrieved January 4, 2013 from http://www4.gsb.columbia.edu/rt/null?&exclusive=filemgr.download&file_id=7214615&rtcontentdisposition=filename%3DHenry-Hu-Yale-Law-Journal-Misunderstood-Derivatives.pdf Newton, L., Englehardt, E., & Pritchard, M. (2011). Taking Sides: Clashing Views in Business Ethics and Society (2nd ed.). New York, NY: McGraw-Hill. TABB Group and BNY Mellon. (2010). Derivatives – Protection Without Suffocation: Thriving in a New Era of Regulatory and Market Transformation. [Electronic Version]. The Thought Leadership Series. Retrieved January 4, 2013 from http://www.bnymellon.com/foresight/pdf/derivatives.pdf Read More